Does the current bullish market awaken latent urges in you for bigger returns in your portfolio? If so, you’ll be interested in the new science of neuroeconomics and current research about investor behavior and emotions.

Jason Zweig , personal finance Wall Street Journal columnist and author of Your Money and Your Brain: How the Science of Neuroeconomics Can Help Make You Rich, has researched a new discipline called neuroeconomics, combining biology, psychology and economics to explore why investors make emotionally charged financial decisions. In his research, he examines why emotion overrules reason for most investors and what makes investors confident that they can reliably predict the future.

Rats outperform humans

He asserts that, unlike other animals, humans believe they are smart enough to forecast the future, even when they know it is fundamentally unpredictable. An example of this has been demonstrated for decades by psychologists who have illustrated that rats stick well within the limits of their abilities to identify patterns, resulting in a natural humility in the face of random events. Humans, on the other hand, are a somewhat different story.

In a typical experiment, researchers flash two lights: one green and one red. With the exact sequence being random, but the odds known to the subjects, the green light flashes 80 percent of the time, and the red light comes on the other 20 percent of the time.

In guessing which light will come on next, the best strategy is simply to pick green every time, since there is an 80 percent chance of being right. And that’s what rats generally do when they get rewarded a couple of times for the right choice. Not so with humans, however. Instead of picking green all the time and locking in the win, people quickly get caught up in the game and assume they can create more attractive odds by guessing right, even with no history of favorable outcomes. But, on average, abandoning a long-term balanced strategy allows impulsive investors to pick the next flash accurately only 68 percent of the time. In a profound evolutionary irony, it’s the rats that are outperforming the humans in this kind of task.

Avoiding irrational exuberance

Yes, at the time of this writing, the markets were near their highs. And, Mr. Zweig demonstrates plenty of parallels between his research and investor behavior. For instance, many investors decide to get in and out of markets based on short-term news or forecasts. “Irrational exuberance” or misplaced confidence in their ability to time the market spurs them on. But bear in mind that if you’re right once, you need to be right at least twice, getting out and in at just the right time, and then you need to repeat that success over and over again in order to consistently win big.

Gordon Gecko, it turns out, was wrong: greed is decidedly not good, and the current hot market should not silently urge you to act; history contains the proof to which you can turn for confidence in your plan. If investors simply employ a balanced strategy for the long-term in the first place (i.e. guess green on every flash), they have historically been richly rewarded as shown below:

The S&P Stock Index has been up 63 out of 87 years or 72 percent of the time from 1926-2012, and has produced an annualized compound return of 9.84 percent.

A portfolio consisting of 60 percent S&P 500 and 40 percent five-year U.S. Treasury notes has been up 67 out of 87 years, or 77 percent of the time from 1926–2012 with an annualized compound return of 8.57 percent.

Mr. Zweig points out that there’s a particular section of the brain called the amygdale (uh mig’dull uh) which plays a primary role in processing emotional reactions (fear, greed, anger, etc). The amygdale reacts with incredible speed, which helps keep humans alive when confronting natural dangers such as a rattlesnake slithering across the path or a dog jumping to bite. However, when investors are confronted with volatile markets accompanied by overwhelming media coverage, immediate impulses generated by the amygdale can lead to reactions which may not be wise in the long run.

Emotions can undermine rational investing decisions

Most educated investors know what they are supposed to do: diversify, shut out the short-term noise of the market, rely on low-cost funds, and systematically trade securities without emotion when stock or bond markets make significant moves. Most investors, however, simply do not act rationally when it comes to big swings in the market. Mr. Zweig’s central thesis, based on his research, is that the part of the brain that responds to emotions is not an optimal tool for making financial decisions. Instead, rather than sitting back and enjoying the overall strength of the current markets, the part of the brain that tells investors to act rationally is abandoned in favor of more powerful emotional impulses — impulses, Mr. Zweig observes, “that make us human.”

He still remains an optimist, however, because he thinks people can learn to resist their emotions and, with a little effort, focus on the rational basis of long-term investing, and appreciate the benefits of a well-managed and stable investment plan.

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Mark Keating, CFP, AEP, is a certified financial planner and an accredited estate planner with Willow Creek Financial Services (707-829-1146, wcfsinc.com), Sebastopol, one of the leading wealth management firms in California. Wealth Matters is a monthly column from the firm’s partners.

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